5 Policy Advice and Actions during the Asian and Global Financial Crises SIMON JOHNSON AND JAMES KWAK It is certain that a healthy fi nancial system cannot be built on the expectation of bailouts. –US Treasury Secretary Lawrence Summers, January 2000 For at least a decade, few people thought that the “emerging-market” crises of 1997–98 had something to teach the United States, the world’s richest economy and fl agship democracy. The differences between Indonesia or the Republic of Korea and the United States are obvious: income level, fi nancial system, political track record, and so on. US policymakers did draw a number of important lessons from those emerging-market crises—for other emerging markets. Treasury Secretary Lawrence Summers outlined the main points in a high-profi le lecture at the 2000 conference of the American Economic Association. Financial crises were the result of fundamental policy weaknesses: “Bank runs or their interna- tional analogues are not driven by sunspots: Their likelihood is driven and determined by the extent of fundamental weaknesses.” It was more impor- tant to look at the soundness of the fi nancial system than to simply count the total amount of debt: “When well-capitalized and supervised banks, effective corporate governance and bankruptcy codes, and credible means of contract enforcement, along with other elements of a strong fi nancial system, are present, signifi cant amounts of debt will be sustainable. In their absence, even very small amounts of debt can be problematic” (Summers 2000). Companies should not be allowed to expect government support in a time of crisis: “It is certain that a healthy fi nancial system cannot be built on the expectation of bailouts.” And in a time of crisis, it was critical to take rapid action to clean up failing banks: “Prompt action needs to be taken to maintain Simon Johnson, senior fellow at the Peterson Institute for International Economics since September 2008, has been the Ronald A. Kurtz Professor of Entrepreneurship at MIT’s Sloan School of Management since 2004. James Kwak is associate professor at the University of Connecticut School of Law. This chapter draws on their joint work, including Johnson and Kwak (2011). 141 © Peterson Institute for International Economics | www.piie.com fi nancial stability, by moving quickly to support healthy institutions and by intervening in unhealthy institutions” (Summers 2000). The best advice Summers offered was a principle famously associated with Mexican president Ernesto Zedillo during a crisis earlier in the decade: “Markets overreact, so policy needs to overreact as well.” These were all valid conclusions. In summary, they meant that emerging- market countries should become more like the United States, with strong legal institutions, transparent accounting, elaborate bank regulations, and an inde- pendent political system—or, more accurately, they should become more like the conventional image that we held of our own country. The idea that a major fi nancial crisis of the type that ravaged emerging markets in the 1990s could originate in the United States was too preposterous to even be conceived of. Two of the crucial ingredients—tight connections between economic and political elites and dependence on fi ckle short-term fl ows of foreign capital— seemed completely out of the picture. Despite rising foreign debt due to growing trade imbalances, Summers’ argument implied that the US superior fi nancial system made high debt levels sustainable. More fundamentally, the implication was that political economy— the study of interactions between the political and economic systems—was only of fi rst-order importance for developing and emerging-market countries. In countries that had already “emerged,” like the United States, economic questions could be studied without reference to politics. Instead, economic and fi nancial policy presented only technocratic questions, which Summers compared to regulation of air travel: The jet airplane made air travel more comfortable, more effi cient, and more safe, though the accidents were more spectacular and for a time more numerous after the jet was invented. In the same way, modern global fi nancial markets carry with them enormous poten- tial for benefi t, even if some of the accidents are that much more spectacular. As the right public policy response to the jet was longer runways, better air traffi c control, and better training for pilots—and not the discouragement of rapid travel—so the right public policy response to fi nancial innovation is to ensure a safe framework so that the benefi ts can be realized, not stifl e the change. But in September–October 2008, when Lehman Brothers collapsed and panic seized the US economy, funds fl ooded out of the private fi nancial system in what resembled aspects of a classic emerging-market crisis. In retrospect, it was clear that the run-up in housing prices of the 2000s was a bubble fueled by overoptimism and excess debt worthy of any emerging market. The diagnosis of the International Monetary Fund’s 1997 Korea letter of intent seemed to apply perfectly to 2008 America (substituting “household” for “corporate”): “Financial institutions have priced risks poorly and have been willing to fi nance an excessively large portion of investment plans of the corpo- rate sector, resulting in high leveraging. At the same time, the dramatic decline in stock prices has cut the value of banks’ equity and further reduced their net worth” (IMF 1997a). And when the US federal government began rescuing major banks presided 142 RESPONDING TO FINANCIAL CRISIS © Peterson Institute for International Economics | www.piie.com over by ultrawealthy executives—while letting smaller banks fail by the dozens— it began to seem as if our government was bailing out a very specifi c element of the American elite. In similar situations in the 1990s, the United States had urged emerging-market countries to deal with the basic economic and political factors that had created devastating crises. This advice was often perceived as arrogant (especially when the United States also insisted that crisis-stricken countries open themselves up further to American banks), but the basic logic was sound: When an existing economic elite has led a country into a deep crisis, it is time for change. And the crisis itself presents a unique, but short-lived, opportunity for change. As in the Republic of Korea a decade before, a new president came to power in the United States in the midst of the crisis. And just like Kim Dae-Jung in the Republic of Korea, Barack Obama had campaigned as the candidate of change. Yet far from applying the advice it had so liberally dispensed to others, the US government instead organized generous fi nancial support for its existing economic elite, leaving the captains of the fi nancial sector in place. What happened and why? This chapter compares and contrasts advice given to Asia during 1997–98 with what the United States actually chose to do in the crisis of 2008–09 and the fi nancial reform phase that followed. Has best practice for dealing with fi nancial crises changed or is it one set of rules for emerging markets and another for the United States? And if recent actions by the US authorities have increased the degree of moral hazard and enshrined some version of “too big to fail” beliefs, what does that imply for global fi nancial stability—and for Asia—looking forward? The Asian Financial Crisis In the mid-1990s, fi nancial crises in less rich parts of the world were only too common. Mexico had a major meltdown in 1994–95, the Russian Federation struggled with volatility caused by fi nancial infl ows and outfl ows through 1996, and banking systems in the Czech Republic, the Ukraine, and other former communist countries struggled with severe shocks. Then in 1997–98, what seemed like the mother of all international fi nancial crises swept from Thailand through Southeast Asia to the Republic of Korea, Brazil, and the Russian Federation. The contagion even spread to the United States via Long- Term Capital Management (LTCM), a relatively large and inappropriately named hedge fund. In the United States, economists and policymakers took two main lessons from these crises. The fi rst was that other countries needed to become more like the United States. Both directly and through their infl uence over the IMF, the key architects of US economic policy—Treasury Secretary Robert Rubin, Deputy Treasury Secretary Lawrence Summers, and Federal Reserve Chairman Alan Greenspan—pressed crisis-stricken countries to liberalize their fi nancial systems, increase transparency in their political systems, and model the gover- nance of their corporations on the Anglo-American system (with a greater role for mutual funds and other institutional investors). For their pains, the Rubin- POLICY ADVICE AND ACTIONS 143 © Peterson Institute for International Economics | www.piie.com Summers-Greenspan trio was featured on the cover of Time magazine as the “Committee to Save the World.”1 The second lesson was that while the US economy was not completely immune to fi nancial panics, any real damage could be contained through a few backroom deals. At the urging of the Federal Reserve, LTCM was essentially bought out and refi nanced by a group of private sector banks, preventing a major crisis; a series of interest rate cuts by the Fed even kept the stock market bubble growing for another two years. The mature US fi nancial system, it seemed, could withstand any infection that might spread from the developing world, thanks to its sound fi nancial system and macroeconomic management. Crises were for countries with immature economies, fi nancial systems, and political systems that had not yet achieved long-term prosperity and stability— countries like the Republic of Korea, Indonesia, and the Russian Federation.